Death and Taxes

New Laws May Force You to Rethink Your Estate Planning

David York, Esq., CPA and Andrew L. Howell, Esq., TEP

June 6, 2013

For the past 12 years, estate planning, and federal estate tax planning in particular, has been subject to tremendous uncertainty and change. Estate taxes were scheduled to be repealed over a 10-year period as a result of the passage of the so-called “Bush Tax Cuts” in 2001. However, the permanency of those changes required ratification by a future Congress.

For a variety of reasons, permanent repeal never occurred. Without any action by Congress, estate and gift tax rates were scheduled to increase in 2013 to 55 percent on estates and/or gifts of $1 million or more.

What Changed

At the end of 2012, three important legislative changes occurred. First, the estate tax exemption was increased to $5.25 million per person. Second, Portability (described below) was made permanent and became a huge potential estate tax planning tool. Third, at the same time Congress was easing estate tax rates and increasing the applicable credits against the tax, it was simultaneously increasing income tax rates and reducing the benefits of itemized deductions and personal exemptions.

In other words, estate taxes became a significantly smaller issue for the vast majority of Americans while, at the same time, income taxes became a much bigger issue, especially for individuals inheriting appreciated assets.

Beginning in 2011, Congress established Portability, which essentially allows a surviving spouse to “inherit” and utilize the unused estate or gift tax credit of his or her deceased spouse. For example, if a spouse with $1 million in assets died first, the surviving spouse could elect to receive his or her spouse’s unused $4.25 million and utilize it upon their death.

In order to transfer the credit to a surviving spouse, a 706 Estate Tax Return must be filed within nine months of the date of death of the first spouse to die.

New Challenges

Because most estate plans currently in existence don’t take the recent dramatic changes to the law and the shift in taxation into account, traditional plans can cause some significant problems.

First, if the estate plan establishes a trust that uses any portion of a deceased spouse’s estate tax credit, then the only way to take advantage of Portability is to file a detailed Form 706 and provide in-depth valuation information on all of the assets going into that trust. If a detailed Form 706 isn’t filed, then Portability is lost. Second, that trust will be required to file taxes each year as a complex trust for federal income tax reporting requirements. Third, upon the death of the surviving spouse, none of the assets in that trust would be eligible for a “step-up” in basis (an adjustment in the basis of assets upon a person’s death to the then-current fair market value).

You could attempt to take advantage of Portability and basis step-up by simply transferring the assets of the first spouse to die directly to the second spouse. The problem is that, if you do that, you lose the asset protection benefit of an irrevocable trust and subject those assets to potential creditor claims or the claims of a future spouse.

Fine-tuned Strategy

If it has been awhile since you’ve met with your financial advisor, now might be a good time to re-evaluate your estate plan in light of the recent changes to tax law. Every situation is unique, and your advisor should be able to create a plan that best fits your needs.

For example, we designed the Marital Step-Up Trust in order to combine the advantages of Portability, step-up in basis and asset protection into a single trust. Unlike a traditional estate plan, the Marital Step-Up Trust allows a surviving spouse to take advantage of full Portability by filing a simplified 706 Estate Tax Return without any valuation requirements. Also, heirs will receive a full step-up in basis upon the death of the surviving spouse, which is even more important now in a higher income tax rate environment. Finally, it will be taxed as a simple trust, which makes it much easier to file and report the trust’s income.

Again, due to the complexities of estate and tax laws, every family has unique hurdles and concerns. For instance, couples with larger estates, individuals in second marriages and those concerned about protecting their assets will need in-depth estate planning.

The dramatic estate and income tax laws that occurred at the end of 2012 have resulted in a fundamental shift in how an effective estate plan should be drafted and implemented. It is important that you have your current planning reviewed to make sure it is taking full advantage of these changes so that you can not only effectively and efficiently manage your estate, but also limit the potential impact on your estate by taxes or future creditors.

David York, Esq., CPA and Andrew L. Howell, Esq., TEP are with the law firm of York Howell.